Panic Selling? Why Investors Are Dumping Dividend Stocks

The fear of higher taxes has put a chill on dividend-paying stocks, in what some analysts say could be an overreaction to the "fiscal cliff."

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The Bush-era tax cuts on dividends and capital gains, to 15 percent, are in the cross hairs, as congressional leaders and President Barack Obama this week start work on reshaping the tax and spending components of the so-called fiscal cliff.

The cliff is the $607 billion expiration of a bundle of tax cuts and other programs, and the onset of automatic spending cuts that take place starting Jan. 1 if Congress does not act.

For dividend investors, a worst-case scenario for the wealthiest Americans would be that the upper income tax rate is returned to 39.6 percent, and dividends could then be taxed at that much higher rate, if the Bush tax cuts are left to expire.

In that case, dividends could be taxed at a steep 43.4 percent for the upper income bracket, and capital gains would be at 23.8 percent for the top rate, if the Bush tax cuts expire without change. Even if the tax cuts were maintained, dividends would be taxes at 18.8 percent for the richest Americans.

Sam Stovall, chief equity strategist at S&P Capital IQ, said dividend-paying stocks have been hit harder than most in recent weeks, in anticipation of higher dividend taxes in 2013, as well as a possible higher capital gains tax. (Read More: Fiscal Cliff—Complete Coverage)

"The real question is how will investors respond. I think some of these groups will be and have been beaten up because a lot of these investors were riding the momentum wave for high yielders," Stovall said. "As a result, a lot of these groups were pretty expensive."

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He noted that the high-yielding telecom sector's forward P/E was 17.5, and it has now fallen to 16.6. Utilities, the market's worst performers Monday, are now trading on a forward price to earnings ratio of 14 and consumer staples are near 15. The overall market is at 12.2 times 2013 earnings. Utilities shares were higher on Tuesday.

"Even though they normally trade at a premium to the market because of their consistent earnings and dividend growth, they do look relatively expensive," Stovall said. "At the same time they do offer a good dividend yield. Telecom is close to 5 percent, utilities are 4.5 percent, and consumer staples at 3 percent. … It's almost twice as good as a 10-year note yield."

Stovall said beyond dividend stocks, the whole stock market is at risk if Congress and the White House fail to work out a deal on the cliff issues. "The stock market will fall off its own cliff," he said.

Goldman Sachs economists recently wrote that they believe the ultimate outcome on the dividend tax rate will be that it and capital gains would be pushed to 20 percent rate, as favored by Senate Democrats. But the rate would then be nearly 24 percent for the wealthiest tax payers. Other scenarios include dividend tax rates that would be graduated to a higher level for the rich.

"If an investor wants yield, and they also want an investment vehicle linked to growth, then dividend stocks would still seem to be a good place to be," said John Stoltzfus, chief market strategist at Oppenheimer Asset Management. "In an environment where a market continues to be fairly prone to move from 'risk on' to 'risk off,' it's nice to have an investment to pay you while you wait."

"The Bush-era advantage on dividend stocks was a fabulous deal for investors of all income categories. The question is would that still play to some income levels? We would hope that it would be extended to all investors," Stoltzfus said. Stoltzfus said baby boomers, in particular, would be looking for high-yielding dividend stocks as a source of income in retirement.

In the past month, the S&P 500 is down about 2 percent, but some of the dividend paying sectors were down more. Utilities are by far the worse, down 6.4 percent for the month, and down 4.2 percent year to date. Telecoms were down about 2 percent in the past month, but up more than 12 percent for the year.

Steve Massocca, managing director at Wedbush Securities, is portfolio manager of the Wedbush Hedged Dividend Fund, which he says was up 16.8 percent year to date through Oct. 31. He said as investors head for the exits, they are unfairly treating REITs and MLPs just as they are corporate dividend payers. The dividend income from REITs and MLPs is nonqualified and taxed at the individual tax rate.

"I view the selloff in MLPs as a buying opportunity. I view the selloff in all these dividend paying companies as a buying opportunity," said Massocca.

He pointed to the Alerian MLP , which investors have been dumping. "It lends itself to panic selling, and that's what it looks like right now," said Massocca.

"Utilities got killed and that makes sense. That's a qualified dividend," he said. "It makes no sense with MLPs. They're not qualified dividends."

Stovall said a change in the dividend rate could actually be an advantage for MLPs. "REITs will probably look a little more attractive under the new (possible) tax environment because there's a more level playing field, the same as limited partners," he said.

Stovall said while the market was down 2 percent in the past 13 weeks, residential REITs were down 4.9 percent and retail were down 2.6 percent. Industrial were 0.4 percent higher.

"There are companies that our analysts continue to recommend because they have good earnings growth prospects, attractive valuations and above average consistency of raising earnings and dividends," Stovall said.